Five important formulas to calculate returns on investments

Familiarize yourself on five important formulas that are used to calculate returns.

1) Holding Period Return (HPR)

2) Post Tax Returns

3) Inflation Adjusted Returns

4) Compounded Annual Growth Rate (CAGR)

5) Effective Annual Rate

Let us understand each of these formulas in detail.

1) Holding Period Return (HPR)

Holding period return is the total return received from holding a Financial Asset. It is calculated as income plus price appreciation during a specified time period, divided by the cost of investment.

When we are looking at the return that we earn on our investments, one of of the first measures that we will look at is the Holding period of return. This return includes income from all sources like dividends, interest, periodic receipts and the change in the price of the asset.

Holding Period return is also known as, Absolute return (or) Total Return (or) Historic Return.

Example : Mr. Sinha invested Rs 1,00,000 in stock market . After 2 months he received a dividend amount of Rs 2,000. He sold the shares after 8 months and received Rs 1,12,000. What is the holding period return in this case?

HPR = (2000 + (1,12,000-1,00,000)) / 1,00,000

HPR = 14%

2) Post Tax Returns

Different financial instruments attract different tax rates. It is important to factor in the taxes while calculating your returns on investments. It is used to calculate the actual returns from any investment after paying applicable taxes.

Post-tax returns = Pre-Tax retuns * { (100-Tax Rate) / 100 }

Example : Continuing with the above example, Mr Sinha had to pay 15% as Short Term Capital Gains Tax. So, what is the actual returns (in percentage) after accounting for taxes?

Post-tax returns = 14 * { (100-15) / 100 }

Post – tax returns = 11.9%

3) Inflation Adjusted Returns

This formula can be used to find out the actual returns after adjusting nominal returns to change in prices or inflation. This is mainly used during ‘withdrawal phase’ of your investments. This is also known as ‘Real Rate of Return.’ It is used to determine the actual worth of an investment after adjusting for inflation rate.

Example : Mr. Gupta (Age 59 years) received Rs 25,00,000 as his retirement benefits. He invested this amount in Bank Fixed Deposit. He plans to withdraw the interest amount periodically. The interest rate offered is 9.5%. The average inflation rate is 8%. What is the Real rate of return?

Real rate of return = { [ ( 1 + .095) / (1+.08) ]-1 } * 100

Real rate of return = 1.39%.

4) Compounded Annual Growth Rate (CAGR)

CAGR is the year-over-year growth rate of an investment over a specified period of time. It is known as Annualized returns. Is is mainly used to compare performances of mutual funds, stocks etc.,

CAGR = [ { ( 1+ r )^ 1/n } – 1 ] * 100

(r = Holding period or total return and n = Time)

Example : Mr. Iyer invested Rs 1,00,000 in a mutual fund scheme. After 4 years, he sold the mutual fund units and received Rs 1,35,000. Calculate Holding period return and CAGR?

HPR = (135000 -100000) / 100000

HPR = 35%

Whereas, CAGR = [ { ( 1+.35)^1/4 } -1 ] *100

CAGR = 7.79%

Holding period return is 35% for 4 years. The annual growth rate will not be 35/4 = 8.75%. But, it will be less than this figure which is 7.79% as growth is compounded.

If the holding period is 1 year then CAGR and HPR will be the same. If the holding period is more than 1 year then the CAGR will be less than the HPR.

5) Effective Annual Rate

The formula for converting the nominal return into an effective annual rate is as below:

Effective Annual Rate = { ( 1 + r )^n – 1 } * 100

( r = nominal return divided by no of compounding in a year)

(m = no of compounding in a year. 12,4,2 and 1 for monthly, quarterly, half-yearly and annually respectively.)

Example: Mr. Gowda invests some amount in a bank fixed deposit. The interest rate offered is 9% pa, compounded quarterly. What is the effective annual rate in this case?

Effective Annual rate = { ( 1 + .09/4) ^ 4 -1 } * 100

Effective Annual rate = 9.3%

Hope this post is useful to you. Make use of these formulas while analyzing your investments. You may execute these formulas using financial calculator or on MS excel. Kindly share your views.

Sreekanth Reddy

Sreekanth is the Man behind ReLakhs.com. He is an Independent Certified Financial Planner (CFP), engaged in blogging, financial counseling & property consultancy for the last 6 years through his firm ReLakhs Financial Services . He is not associated with any Financial product / service provider.
The main aim of his blog is to "help investors take informed financial decisions."